Federal Reserve Chair Jerome Powell. AFP.
Federal Reserve Chair Jerome Powell. AFP.
As the pandemic began in 2020, the Federal Reserve slashed interest rates and printed money to buy Treasury bonds (quantitative easing, QE).
Source: Bank of Singapore, Bloomberg.
The first chart shows the Fed’s balance sheet more than doubled from USD4 to USD9 trillion. The second chart shows the Fed’s printing of money led to a huge jump in financial sector liquidity with bank reserves deposited at the Fed surging from USD1.6 to over USD4 trillion. The central bank’s vast support to both the US economy and the financial sector thus helped equities soar after the shock as the first chart also shows.
After the US reopened and inflation surged, the Fed reversed course in 2022 and began hiking interest rates and letting its balance sheet shrink (quantitative tightening, QT).
Source: Bank of Singapore, Bloomberg.
As its bond holdings matured, the Fed ceased reinvesting the proceeds, reducing its assets (Treasuries) and liabilities (the US Treasury’s cash).
The running down of the Fed’s balance sheet (QT) lowers liquidity in the financial sector. If the central bank doesn’t replace its maturing Treasuries, then the US government has to finance its deficit by selling fresh bonds to banks or other financial institutions like money market funds. This reduces the reserves banks keep at the Fed as the second chart shows. It may also lower the funds deposited at the Fed’s overnight reverse repurchase (ON RRP) facility by banks, money market funds and other players to benefit from the Fed’s now much higher interest rates.
The Fed’s QT can thus hurt equities through reducing financial sector liquidity. It can also hurt by straining weaker banks as occurred in March when several small US banks went bust. The Fed doused that crisis by providing banks with new borrowing facilities. But over the next 6-12 months, QT is set to cause more severe instability.
As the Fed is running down its balance sheet by almost USD100 billion each month, it could drain the USD1.5 trillion held at the Fed’s overnight reverse repo facility by next summer. By that time bank reserves will be increasingly scarce. Thus, the clear risk lurking from the Fed’s QT in the next 6-12 months is further banking crises as weak banks struggle for liquidity, causing fresh runs as we saw in March that hit investor sentiment.
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